Europe’s monetary union has entered a doom loop. Recessions in peripheral Europe are driving down tax revenues and increasing welfare spending. Despite German-imposed austerity programs, deficits keep overshooting the targets. But these governments can no longer borrow at affordable rates. Meanwhile, their banks are hemorrhaging deposits. Up until now, broke banks could prop up broke governments by borrowing from the European Central Bank and using the cash to buy their governments’ bonds. But that game is over. For there is nothing the ECB can do to stop panicky Spaniards swapping “Spanish euros” for “German euros”—in other words, putting their savings into German banks for fear that Spanish accounts will one day be converted back into pesetas.
This is a potentially explosive process. Already the centrifugal forces at work have generated a vast imbalance within the TARGET2 system, which processes payments between the euro-zone member states’ central banks. In effect, the peripheral central banks owe the German Bundesbank €650 billion. This is a figure that grows larger with every passing week.
What makes all of this so terrifying is that it vividly recalls the events of the summer of 1931. It’s often forgotten that the Great Depression, like a soccer match, was a game of two halves. If the first half was dominated by the U.S. stock-market crash, the second was kicked off by a European banking crisis. It began in May 1931, when the biggest bank in Austria, the Creditanstalt, was revealed to be insolvent. The lethal blow was the collapse two months later of the Danat Bank, one of the biggest in Germany…
My best guess is that all this brinksmanship will ultimately end with the Hamiltonian solution: fiscal federalism and, ultimately, a United States of Euro Zone. An important step was taken in this direction over the weekend, with the announcement that 100 billion euros will be made available to bail out Spain’s ailing banks. This was a major victory for the talented Spanish Economy Minister Luis de Guindos, who cleverly asked for more than twice what the International Monetary Fund deemed necessary, and got away with far fewer conditions than were imposed on neighboring Portugal when it sought a bailout. The mood in Madrid this weekend was one of relief, even confidence. But there are all kinds of hazards along the way, not least the impending Greek and French elections. Meanwhile, the world waits—and braces—for a European Lehman Brothers moment.